International standards for payment systems

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International Standards for Payment Systems

Tobias Thygesen, Payment Systems

INTRODUCTION

Payment systems are an important part of the financial infrastructure, and safe and efficient payment systems are essential to the smooth functioning of the financial system. Within the last 10-15 years, the central banks of the G-101 countries have driven the trend for greater focus on the risks associated with payment systems. This development is to a large extent a result of the increasing volumes traded in the systems, and the rapid pace of technological development, both of which have led to a significant increase in the potential risks entailed by the systems. G-10 and the European Monetary Institute (EMI, now the European Central Bank, ECB), amongst others, have published reports with recommendations and standards for payment systems. The latest report on the subject, Core Principles for Systemically Important Payment Systems (Core Principles), from the Committee on Payment and Settlement Systems of the G-10 central banks2, was published on 15 January 2001.

The article outlines what a payment system is, as well as the various types of payment systems, followed by the two key requirements for payment systems: safety and efficiency. A description of the risks associated with payment systems is also included. The role of the central banks in connection with payments and settlements is discussed in the light of previous reports from G-10 and EMI/ECB in particular. Finally, the standards contained in the Core Principles are outlined.

RISKS AND EFFICIENCY OF PAYMENT SYSTEMS

The majority of payments in Denmark are made electronically via payment systems, i.e. IT systems for the transfer of funds.3 Typically, funds

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2 G-10 comprises the ten largest industrialised countries and Switzerland. 3 The report can be downloaded from BIS' Web site: .

BIS has defined payment systems as "systems that comprise a set of instruments, procedures and rules for the transfer of funds among system participants" (Core Principles, page 4).

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are transferred from the payer's account with a bank to the recipient's account with another bank or the same bank. Both cheque payments and Dankort (debit card) payments involve the transfer of funds between bank accounts.

If the recipient does not have an account with the same bank as the payer, the payment is typically part of a transfer between the two banks' accounts with the Nationalbank. A typical customer payment via the banks thus involves two layers: transactions to and from the customer accounts, and a transfer between the two banks' accounts with the Nationalbank via an interbank payment system. However, the largest volume of turnover in the payment systems does not relate to customer transactions, but to interbank trading in the money, securities and currency markets.

Box 1 describes some of the main characteristics of various types of payment systems.

Considerable amounts pass through the payment systems. For instance, the daily turnover in the Bank of England's RTGS system, Chaps, is close to 180 billion pounds sterling, the daily turnover in the American payment systems, Chips and FEDwire, exceeds 2,500 billion dollars, and the daily turnover in the global currency market is estimated to be in the region of 1,500 billion dollars.

PAYMENT SYSTEMS

Box 1

In general terms, there are two types of payment systems. The system used depends partly on the size of the payment.

Large or time-critical payments are typically made via real-time gross settlement systems, RTGS. The payments are effected instantly and finally to the banks' accounts with the settlement bank ? in most countries the central bank. RTGS systems are used mainly for interbank settlements and large payments for corporate customers.

For smaller payments, banks in most countries have established systems which calculate the net position of each participant vis-?-vis the other participants, instead of settling each payment separately and immediately. This is called netting. At set times of the day these net positions are exchanged via the banks' accounts with the settlement bank ? in most countries the central bank. Net settlement systems are typically used for e.g. retail payments such as Dankort transactions (in Denmark), direct debit and cheques.

In recent years, hybrids of these two types of systems have also emerged. Denmark has two real-time gross settlement systems: DEBES in euro and the DN Inquiry and Transfer System in kroner. These systems will be replaced by the Nationalbank's new system, KRONOS, which is expected to be completed in the fourth quarter of 2001. Sum clearing and securities settlement are examples of net settlement systems.

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PAYMENT SYSTEM RISKS

Box 2

Payment systems involve several types of risk: Credit risk: The risk that a participant in the system goes into liquidation or is oth-

erwise unable to meet its full financial obligations at the expected time or later. Liquidity risk: The risk that a participant in the system does not have sufficient

liquidity to meet its financial obligations at the expected time ? although the participant in question may be able to meet its obligations at a later time.

Operational risk: The risk that operational factors, e.g. system downtime or operational errors, result in or amplify credit or liquidity risks.

Legal risk: The risk that an inadequate legal basis for the system results in or amplifies credit or liquidity risks.

Systemic risk: The risk that one participant's difficulties in meeting its financial obligations spread to other participants in the system or to other areas of the economy.

The daily turnover in the Danish payment systems is considerable. The average daily turnover of the Danish RTGS system, DN Inquiry and Transfer System, is around kr. 90 billion, which is more or less equivalent to the total shareholders' funds of the Danish banking sector at the end of 1999, viz. kr. 94.4 billion. The daily turnover in the sum clearing net settlement system is approximately kr. 15 billion, while the daily securities settlement trading volume is around kr. 90 billion. In view of these large volumes, the potential risks faced by the banks are considerable.

Payment systems entail several types of risk, cf. Box 2. For example, if a bank explicitly or implicitly grants a customer credit before final receipt of a payment, or a bank executes its part of a financial transaction before the counterparty has executed its part, the bank runs a credit risk. If a bank counts on using liquidity from payments received from other parties in order to execute its own payments, the bank runs a liquidity risk. The structure and workings of the payment system itself impose operational and legal risks on the participants.

All of the above types of risk can involve systemic risks. Since problems experienced by one participant in a payment system may affect the other participants directly and rapidly, payment systems could potentially transfer problems from one participant to the others. If one participant is unable to fulfil its obligations, or the payment system is down, it can be difficult for other participants to meet their obligations. Such domino effects can lead to extensive credit and liquidity problems, which can be spread from the participants in the system to other parts of the financial system.

Needless to say, systemic risks are greater in systems with high volumes and/or large individual transactions. Payment systems which could potentially cause problems or spread them to the domestic or international

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financial system are referred to as systemically important payment systems. These are typically systems where the total turnover or the size or nature of the individual transactions might give rise to this situation.

As stated above, there is increasing domestic and international awareness of the inherent risks of payment systems. This awareness is presumably one reason for the fact that it is difficult to find examples of financial crises originating in payment systems.

Safe payment systems are thus essential to the smooth operation of the financial markets and to the economy in general. In addition, payment systems must be efficient1.

Traditionally, safety and efficiency are seen as contradictory objectives. For example, the two key types of payment systems, RTGS systems and net settlement systems, cf. Box 1, both present advantages and disadvantages in relation to security and efficiency.

In an RTGS system, where the payments are final immediately after the payment order has been given, the credit risk applies to a shorter period than in a net settlement system, where payments are not final until clearing and settlement have taken place ? typically at the end of the day. On the other hand, the liquidity requirement, and thereby the costs, of a net settlement system are lower. A bank which both sends and receives three payments, each of kr. 50 million, within a day will not need liquidity in a net settlement system, whereas it might require kr. 150 million in a gross settlement system. On the other hand, the legal risks are greater in a net settlement system. Finally, the costs of an RTGS system are higher since such a system requires on-line monitoring and bookkeeping, liquidity and risk management, etc.

Overall, RTGS systems must be considered the more safe of the two, but also the more expensive. An important parameter when deciding which system to use is the size of the transaction. When security is weighed against efficiency, large payments, where the risks are most decisive, are often executed via RTGS systems, whereas smaller payment are typically executed via net settlement systems. For example, the average size of transactions in the DN Inquiry and Transfer System is kr. 55 million, whereas the average size of a sum clearing transaction is kr. 5,000.

However, safety and efficiency can also be complementary objectives in that, for example, improved system design or technological progress can lead to improvement in both. Moreover, the systems must be efficient if they are to be used at all. Even the most safe payment system cannot contribute to financial stability if the costs or encumbrance of

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Payment system efficiency relates particularly to the costs of using the system, but other aspects are also important, e.g. transaction time, ease of use, etc.

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using it are so great that market players are forced to use other, less safe systems.

The role of the central banks in payment systems The role of the central banks in electronic payment systems is twofold.

Firstly, the central banks are bankers to the banks. In many countries the central banks play an operational role in payment systems as the operator of certain systems and also as the settlement bank for other systems. For instance, payment settlements in the Danish payment systems are effected via the accounts of the banks and mortgage-credit institutes with the Nationalbank. There are several reasons for this. Typically, the central bank is the only institution with which all credit institutions have an account, and is thus the natural choice for such operations. Only the central bank can provide liquidity to the banking sector as a whole, since liquidity in fact comprises safe claims on the central bank. In addition, the central bank is neutral in terms of competition.

The second part of the role of the central banks in relation to payment systems is to contribute to the safety and efficiency of the payment systems. This is partly related to the operational role of the central banks and partly to the central banks' general task of helping to ensure financial stability. Furthermore, the central bank is interested in an efficient money market and in maintaining confidence in the national currency. Finally, liquidity support in the event of a crisis typically involves the central bank.

Most central banks worldwide share co-responsibility for maintaining financial stability. The stability of payment and settlement systems is typically considered to fall within the central bank's authority, as an important tool in ensuring financial stability, cf. Box 3.

This role is generally referred to as oversight. The Bank for International Settlements, BIS, defines oversight as "a central bank task, prin cipally intended to promote the smooth functioning of payment systems and to protect the financial system against possible 'domino effects' which may occur when one or more participants in the payment system incur credit or liquidity problems. Payment systems oversight aims at a given system (e.g. a funds transfer system) rather than individual participants".1

Previous efforts to reduce payment system risks In February 1989 BIS/G-10 published a Report on Netting Schemes (the Angell report), which was the first report to focus on the risks related to

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BIS, A Glossary of terms used in Payments and Settlement Systems, Basle, December 2000, page 30. Can be downloaded from .

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OVERSIGHT IN THE ECB AND THE BANK OF ENGLAND

Box 3

Both the Maastricht Treaty and the Statute of the ECB emphasise that oversight is one of the central tasks of the Eurosystem. Thus Article 105 (2) of the Maastricht Treaty and Article 3 of the Statute of the ECB state that "the basic tasks to be carried out through the ESCB [are]... to promote the smooth operation of payment systems", and Article 22 of the Statute of the ECB says that "the ECB and national central banks may provide facilities, and the ECB may make regulations, to ensure efficient and sound clearing and payment systems within the Community and with other countries".

The Bank of England Act 1998 states that the Bank "functions as a supervisor of systems for the transfer of funds between credit institutions and their customers" (see .uk). Recently the Bank has also been made responsible for authorising payment systems. The Financial Services Authority authorises securities settlement systems.

In 1997 the Bank of England, the Financial Services Authority and HM Treasury announced a Memorandum of Understanding determining their various responsibilities in relation to financial stability. The Bank of England is thus responsible for the financial infrastructure, including payment systems. The Bank will be "closely involved in developing and improving the infrastructure, and strengthening the system to help reduce systemic risk". (See bankofengland.co.uk)

payment systems and the central banks' role in this respect. Since then BIS and EMI/ECB have published several reports on payment system risks. The best known is Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries (the Lamfalussy Report, BIS (1990)).1

The Lamfalussy Report is probably the most significant report on the topic so far. Although its scope was originally cross-border net settlement systems, it has proven to be a valuable guide in a much broader context. It is used as a basis for assessing payment systems in most parts of the world and is a benchmark for the objectives to be pursued by central banks when overseeing net settlement systems.

The report sets up 6 standards to be met by net settlement systems for large payments, including a sound legal basis, an understanding of system risks among participants and operators and that the latter have procedures to handle such risks, and that the system must be able to carry out netting even if the largest debtor in the system goes into liquidation. In addition, the report defines a set of principles for the oversight of systems operating in several currencies or across international borders.

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See Jesper Berg, International Observations concerning Payment Systems, Danmarks Nationalbank, Monetary Review, August 1994.

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